Homeowners Get Relief From Forgiveness of Debt Taxation

January 22nd, 2008 1:43 PM

But in late December, a new federal law called the Mortgage Forgiveness Debt Relief Act of 2007 was signed by President Bush. This new law includes several important tax breaks for homeowners, one of which is that forgiven mortgage debt can now be excluded from ordinary taxable income. This exclusion means the homeowner won't have to pay income tax on this amount.

Lenders are still required to report forgiven debt to the Internal Revenue Service, however. That means people who want to exclude such debt from their taxable income should put the amount and reference the new law on their tax returns.

If you've lost your home in a foreclosure, sold your home in a short sale, signed over the deed to your house instead of going through foreclosure or received a loan modification, such as a frozen interest rate, from your lender, you should discuss your personal situation with a qualified tax expert because the new law includes some very specific rules that might not apply to your situation.

The first rule is that the debt must have been forgiven in 2007, 2008 or 2009. The law isn't retroactive to years before 2007 and will expire after 2009. In effect, this timeframe opens a three-year window during which homeowners can escape taxes on forgiveness of mortgage debt.

The second rule is that no more than $2 million of forgiven debt can be excluded from taxable income. That limit should cover most people.

The third rule is that the forgiven debt can be excluded from ordinary taxable income only if the borrowed money was used to buy, build or make substantial improvements to a principal residence. If the money was used to buy a vacation or second home or an investment property, the forgiveness of debt can't be excluded from ordinary taxable income under this law. If the debt was forgiven on a refinanced loan with cash taken out or a home equity loan, the amount of the loan must be divided between the amounts for those allowable purposes and the amounts used for other purposes (e.g., to pay tuition, take a trip or pay off other debts). Only the allowable portion qualifies for the tax break.

Many people already relied on other exemptions to escape owing tax on forgiven mortgage debt. In brief, these exemptions involve non-recourse loans, insolvency and bankruptcy. Again, please consult a qualified tax preparer for advice.

It's also theoretically possible, though unlikely, that someone could owe taxes on capital gains as a result of a foreclosure, short sale or deed-in-lieu of foreclosure. A loan modification would not result in a capital gain.

The new forgiveness of debt tax break is expected to cost the federal government $179 million in 2008 and $318 million in 2009, according to a government report issued in September 2007. States likely will lose some tax money too because their tax rates typically are based on federal adjusted gross income.

Marcie Geffner is a real estate reporter in Los Angeles.

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